Pondering the Small-Cap Risk Premium

It’s been a great year for US stocks, and an even better one for US small-cap stocks. If there’s any doubt about the small-cap premium’s validity, recent history has dispatched the skeptics to the woodshed. For example, small caps (Russell 2000 Index) are up 32% this year through Dec. 13, a handsome premium over the 28% advance over large caps (Russell 1000), according to Russell Investments.

Another way of evaluating relative returns (and considering the historical context in the process) is calculating a rolling 1-year return spread. Let’s take the 1-year return for small caps and subtract the 1-year return for large caps, with the results plotted daily since the mid-1990s:

Using the chart above as a guide, the current small-cap rally has been running strong for more than a year. Although momentum has faltered a bit lately, the small-cap premium is still at a comparatively elevated level at around +8 percentage points. Yes, it’s been higher at times, including a brief, fleeting period in 2000 when the small-cap edge was closing in on an extraordinary spread of +40 percentage points. By that standard, the current premium looks moderate.

The question is whether it’s wise to hold out for even greater gains vs. rebalancing now and taking some profits? Minds will differ, as always, but the track record of reaching for the stars often comes to tears in the money game. That doesn’t mean that small caps won’t continue to dispense outsized returns over large caps in the year ahead. Perhaps, then, it’s wise to rebalance moderately. All or nothing investment decisions can lead to stellar results, but if you’re wrong you’ll pay a hefty price.

Decisions, decisions, although it’s always a good idea to start with first principles before going off the deep end. If you’re inclined to see investing as a risk-management process rather than a return-chasing endeavor, the numbers usually tell you most of what you need to know and when you need to act.